Profiting From The Blood On The Streets?

Baron Rothschild, an 18th-century British nobleman and a member of the Rothschild banking family, is known for his morbid yet true statement that goes, “The time to buy is when there’s blood on the streets”.

In other words, Rothschild is saying that the best time to invest in the market is at its worst when prices are depressed, and everyone is frantically trying to exit the market. Supposing that all the odds were in your favour, you will be rewarded for your boldness and profit tremendously when the market recovers (however long it takes).

Nonetheless, the fear experienced by other investors is understandable. What if the company turns out to be yet another Swiber?

So what exactly is Rothschild saying? Is he suggesting for us to invest despite ailing finance status of companies in hopes of striking the jackpot one day?

Let’s take a look at local investment blogger AK’s approach in a case where he believed there to be “blood on the streets”. Though written back in Feb 2017, we can learn some of the methods that he deploys when analysing stocks.

In the article, he was considering to invest in Centurion Corporation Limitation, a company involved in the business of providing workers and students accommodation. They are, basically, their landlord. Despite the declining share price, AK saw the potential to invest, how did he do it?

He started off by considering the reasons why he should not invest in Centurion. For example, if the company has an obsolete business model that is no longer relevant, we should not be blindly investing in a sinking ship.

AK pointed out two major weakness of Centurion, namely, 1. high leverage level and 2. “a weakening business environment”. When share prices are falling as the economy is not doing well, it is common that demand for products and services will fall, and revenue will decline.

However, the key is to find the companies that are resilient enough to withstand the tough times and rebound afterwards to give you profits.

Cash flow as the lifeblood of a business

A sign of resilience is found in the company’s cash flow. Cash Flow is indeed the lifeblood of business, and as AK mentioned, “during bad times, highly leveraged businesses with reduced cash flow would find themselves in a pinch”.

In the case of Centurion, AK considered its interest coverage ratio (EBIT/interest expense) to investigate if the company was able to repay its outstanding interest costs based on its operating cash flow. At that time it was at 3.4x, a ratio that, according to him, “isn’t fantastic… but it shows interest expense is manageable”.

To put it simply, examine the company’s cash flow to see if they can withstand the challenges of slowing demand in a sluggish economy and meet their payments as they are due. That is much like how you will examine your personal finance to check if you can pay your bills on time.

Leverage level

Next, AK examined the leverage level of the company by comparing its debt against its assets to calculate its gearing level i.e. how much is funded by debt as compared to equity. At that time it was at 74.5 percent which was considerably high.

However, AK mentioned that “if a high debt level is matched by an ability to service the debt, it becomes less of concern”.

Dividend yield for passive income

Next, AK considered how much he expected the dividend yield to be based on several assumptions.

He examined the impact of a 1.0-percent increase in interest rate on the company’s earnings per share with an increase in interest expense. Given that companies sometimes pay a certain percentage of its earnings as dividends, decreased earnings means lesser dividends for investors.

That will be of concern to those who are investing for passive income like AK. For detailed numerical example, refer to his blog post.

Still, the question remains: When to buy?

AK provided some insights into how he determined he should have entered when “the share price did a retracement after breaking resistance provided by the 200-day MA (moving average)”.

What did he mean by that?

Think of resistance as a price wall, a top point where the stock price will find it hard to move beyond. Support acts as the opposite; it is like a price floor where the stock price is unlikely to go any lower, and will likely rebound upwards.

As AK mentioned, the stock broke resistance which means that it exceeded the “price wall” and went above the 200-day MA.

Investors typically see this as a signal to buy as an upwards momentum usually follows the breakout, meaning that prices are likely to continue to rise. Hence, when price retraced (i.e. came down), he should have entered the market when others were exiting momentarily.

However, he concluded that paying 38 cents per share is still a “fairly good price” according to fundamental analysis. Given that stock price is now 47 cents at the time of writing, we can say 38 cents per share was indeed not a too shabby an entry price in hindsight.

Key takeaway: exercise caution to avoid bleeding

At the end of the day, we still believe in value investing – buying stocks at less than their intrinsic price.

Therefore, if you had done your fundamental analysis well, you will have an idea of how much you think the stock is worth.

Look out for a reason for the drop in share prices. Is the company not doing well because of cyclical reasons?

If the business itself is sound and sustainable in the long run, we can get ready to enter whenever market-related issues cause the stock to fare poorly. Afterwards, we simply curl up on our beds with a nice cup of hot chocolate and wait till it recovers.

However, if the decline is structural like how Nokia phones just became increasingly irrelevant, and even obsolete in the smartphone era, we will have to be careful before jumping in simply because the price is low.

Rothschild may say, “buy when there is blood on the street”, but the importance of doing all the necessary homework and analysis before taking the plunge cannot be understated.